Background Information About 12b-1 Fees
Expanding Investor Choice
Innovations in the mutual fund industry have given investors many choices about how and where they purchase mutual fund shares. Some investors prefer to buy mutual funds directly from the company sponsoring them. Others choose to purchase funds through brokers, financial planners, and other financial professionals who provide assistance and advice in selecting funds to help investors reach their long-term goals, such as retirement and education.
The vast majority (approximately 80 percent) of mutual fund purchases are made by investors through financial intermediaries, such as brokers, financial advisers and employer-sponsored retirement plans. Just as investors have a choice in how they buy a mutual fund, they often have options in how they compensate sales professionals for their advice and services.
What Is a 12b-1 Fee?
12b-1 fees, also known as distribution fees, are one component of a mutual fund’s annual fund operating expenses and can be thought of as an alternate way of paying sales-related expenses, such as compensating investment professionals. A fund can have 12b-1 fees only if its board of directors has approved a 12b-1 plan authorizing their payment.
The Purpose of 12b-1 Fees
Rule 12b-1 authorizes mutual funds to use their assets to pay for marketing and distribution expenses, such as compensating sales professionals.
Since their introduction, Rule 12b-1 plans have provided an important addition to the choices investors have in how to pay for their fund shares. The rule allows mutual funds to offer different distribution pricing arrangements to meet the needs of different investors. Many mutual funds make this possible by offering investors various “classes” of shares.
Share classes offer investors a choice in how to pay for a fund. Class A shares generally have a front-end sales charge (“load”) and no, or a low, 12b-1 fee. Class B shares usually have no upfront sales charge but do have a “contingent deferred sales charge” (sometimes referred to as a “back-end” load or sales charge) if shares are sold within a certain number of years; and a 12b-1 fee. After a period of time, B shares typically convert to A shares. Class C shares may have a higher 12b-1 fee, but generally do not have front-end or back-end sales charges. A broker or financial adviser is responsible for recommending a suitable share class for a particular investor. Institute research shows that more than half (63 percent) of all mutual fund share classes have 12b-1 plans and 50 percent of all mutual fund assets are in share classes with 12b-1 plans.
Use of 12b-1 Fees
Percent of total 12b-1 fees
An Institute survey found that covering the costs of compensating broker-dealers for the sale of fund shares and related expenses is the most common use of 12b-1 fees, followed by paying for expenses associated with administrative services provided to existing shareholders by third parties, such as processing shareholder transactions and maintaining shareholder records. Only 5 percent of 12b-1 fees are used to pay for advertising and other sales-promotion activities.
Rule 12b-1 also permits a fund to spread its distribution expenses over several years. When a fund is closed to new investors, it may continue to pay 12b-1 fees to fulfill obligations for past distribution efforts. However, a fund that does not make new sales eventually must reduce or eliminate its 12b-1 fee under applicable regulations.
|A Matter of Choice: Different Investors Acquire Mutual Fund Shares in Different Ways
When the Investment Company Act was enacted in 1940, investors typically purchased mutual funds through brokers and paid a sales commission to compensate these financial professionals for their services at the time of purchase. Today, mutual fund shareholders have more options when deciding to buy mutual fund shares. The chart below shows how different types of investors generally acquire their mutual fund shares.
The vast majority of mutual fund investors want professional financial advice and the services of an investment professional to help them select mutual fund shares. These "advice seekers" generally buy funds through broker-dealers, investment advisers and financial planners, and banks and insurance companies. They pay for the advice and services they receive through sales commissions and 12b-1 fees.
Investors who are comfortable making their own investment decisions may purchase mutual fund shares directly from some fund companies. Most of these direct-marketed funds do not charge a sales commission when shares are bought or sold, and are known as "no-load" funds. They may have an annual 12b-1 fee of no more than 0.25 percent of the fund's net assets.
Many individuals purchase mutual funds at work through a retirement plan such as a 401(k). In most cases, any sales loads are waived for mutual funds offered through retirement plans.
Some mutual fund investors prefer the convenience of selecting from a variety of mutual funds offered by different mutual fund companies through a single source, known as a "fund supermarket." Many funds that are sold through fund supermarkets adopt a 12b-1 plan to finance the fees charged by the fund supermarket's sponsor.
12b-1 Fees are Fully Disclosed
All mutual fund fees and expenses are fully disclosed in a standardized fee table that is required to be at the front of a fund's prospectus. If a fund has a 12b-1 fee, it will be clearly identified in the fee table as part of the fund's annual operating expenses, which, unlike shareholder fees, are not charged directly to an investor but are deducted from fund assets before earnings are paid to shareholders. Investors also can determine whether a fund charges a distribution fee by reviewing the mutual fund listings published in most newspapers. A newspaper's listings offer information about a fund's fees by using a series of symbols next to the fund's name. A fund that has a 12b-1 fee will have the letter "p" next to its name in the newspaper. Federal law requires mutual funds to report their performance on a net basis, after deducting expenses such as 12b-1 fees, so an investor who examines the performance of a fund is indirectly taking into account 12b-1 fee expenses.
Oversight and Regulation
Under Rule 12b-1, a mutual fund must have a written plan that outlines all significant aspects of the proposal to finance distribution. The plan must be approved by a vote of the fund's directors and of its independent directors, who must constitute at least a majority of the board. The rule requires fund directors to request and evaluate information needed to decide whether a plan should be approved or continued. Directors also review the amounts spent under the 12b-1 plan and the reasons for these expenditures. Shareholders must approve any material increase in a fund's 12b-1 fee.
In addition to the procedural and other protections of Rule 12b-1, the National Association of Securities Dealers (NASD) imposes two types of limits on 12b-1 fees. One is an annual limit on asset-based sales charges of 0.75 percent of a fund's assets. (An additional 0.25 percent "service fee" may be paid to brokers or other sales professionals in return for providing ongoing information and assistance.) The other is a rolling cap on total sales charges, to be calculated at 6.25 percent of new sales (plus interest) for funds that pay a service fee, and 7.25 percent plus interest for funds that do not pay a service fee. NASD rules also prohibit any fund with a front-end, deferred, or asset-based sales charge to be referred to as "no load", except for a fund with no front-end or deferred load and a 12b-1 fee that does not exceed 0.25 percent of average annual net assets.
Over the past two decades, the total cost of investing in mutual funds has declined substantially while investor services have proliferated. Research by the Investment Company Institute found that between 1980 and 2001, the average cost of equity mutual funds decreased 43 percent; bond funds, 41 percent; and money market funds, 35 percent.
Distribution Cost for Equity Load Funds,* Selected Years
*Sales-weighted average of 12b-1 fee and annualized load.
Distribution Cost Trends
Since Rule 12b-1 was adopted in 1980, the cost of distribution incurred by mutual fund shareholders has fallen significantly, reflecting industry competition. Before 1980, virtually all distribution costs were paid through a fund's front-end load. As funds adopted 12b-1 plans and expanded distribution payment options for investors, front-end loads declined sharply, while 12b-1 fees absorbed a larger portion of the distribution costs. By 2001, for example, 12b-1 fees amounted to approximately 48 percent of the total distribution cost of load funds. Overall, the decline in loads more than offset growth in 12b-1 fees, leading to the substantial decline in distribution costs.
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